Economist, Telegraph Columnist, Broadcaster

Currency wars ahead as funny money lets rip

In September 2010, Brazilian Finance Minister Guido Mantega pointed his rhetorical finger at the United States and accused the world’s largest economy of conducting a “currency war”. Suggesting that emerging markets were being unfairly squeezed by a falling dollar, which makes US exports more competitive, Mantega lit the touch paper on a controversy that won’t go away.

For now, “currency wars” are a relatively arcane debate limited to foreign exchange specialists and diplomats. But this issue has already adversely affected hundreds of millions of people who consider themselves largely immune to the vicissitudes of international markets, not least in the UK. History shows, also, such currency disputes can escalate from rhetorical spats into disastrously counter-productive economic conflict.

“Currency wars” have hit the headlines anew in recent weeks, given Japan’s attempts to force down the yen. Freshly-installed Prime Minister Shinzo Abe, determined to stimulate a moribund economy, has ordered Japan’s ultra-conservative central bank to be more expansionary.

The Bank of Japan has announced it will raise its inflation target to 2pc, while trying to reach that goal “at the earliest possible date” and phasing-in hefty government debt purchases. Governor Masaaki Shirikawa will also be replaced by a more compliant successor when he retires in April.

Japan has been treading economic water for over 20 years, ever since its almighty real estate bubble burst in the early 1990s. Still the world’s second-largest economy when the credit crunch began in late 2007, the country has since slipped back to third-place and counting, its GDP having contracted for 6 of the last 8 quarters. Despite all that, Abe’s decision to take drastic measures has sparked a chorus of complaints.

The yen spent 2012 oscillating around 80 to the dollar. Since then, it has fallen rapidly and is now approaching 93 to the US currency. Most analysts expect a further slide – not least as the central bank is now committed to aggressive monetary measures and a higher inflation target.

This has big implications for other Asian exporters, as a weaker yen makes Japanese goods cheaper in foreign markets. Since the middle of last year, the South Korean won, for instance, has risen over 30pc against the yen. That’s why politicians in Asia’s fourth-largest economy, which competes with Japan in many sectors including autos and electronics, were last week threatening measures to discourage capital from flowing into the won, stopping it rising even more.

Germany, also, is deeply concerned about the yen’s recent fall and the prospect of further weakness. With an eye on his country’s all-important export sector, Bundesbank President Jens Weidmann recently mauled Tokyo’s new affinity for loose money, referring to “alarming infringements” and an “end to central bank autonomy”.

The danger is that semi-covert moves to depreciate a currency then become aggressive, jingoistic devaluations. Such retaliatory “beggar-thy-neighbour” policies sparked the explicit capital controls and sky-high trade barriers of the early 1930s that, in turn, eviscerated global commerce and caused the Great Depression.

It’s a historical lesson Germany’s central banker was keen to recall. “Whether intended or not, one consequence [of Japan’s action] could be the increased politicization of the exchange rate,” Weidmann said. “Until now the international monetary system got through the crisis without competitive devaluations and I hope very much it stays that way”.

As a long-standing critic of excessively loose monetary policy, I’m not particularly impressed by Tokyo’s latest move. The Japanese people would be much better served by courageous reforms to increase labour market flexibility and exposed their zombie banks to reality, so unleashing, once more, this nation’s huge commercial talents.

Having said that, while the yen has fallen over 10pc against the dollar and 15pc against the euro since Abe took power, it must be recognized that, for several years after the credit crunch, Japan suffered from an artificial appreciation – given Tokyo’s refusal to engage in the “extraordinary measures” taken by leading central banks elsewhere.

Since early 2008, for instance, the US Federal Reserve has expanded its balance sheet by 220pc. Even the European Central Bank, relatively late to the money-printing party, has now clocked-up a 98pc expansion. The Bank of Japan, in contrast, largely eschewing quantitative easing in recent years, has overseen balance sheet growth of 30pc over the last four years – large under normal circumstances but, in these incredible times, a model of monetary probity.

Currency movements are caused, the economic textbooks tell us, not only by trade flows but, above all, by interest rate differentials. In a world of near-zero Western interest rates – negative, if adjusted for inflation – the usual rules don’t apply. Currency values are now overwhelmingly driven by the extent to which central banks print money.

This on-going “ugly contest” among the so-called “advanced economies” is itself a result of attempts by the Western political classes, via QE, to artificially inflate asset prices, bail-out busted banks and suppress real bond yields, while debasing and devaluing the size of the debts we owe the rest of the world. Yet this disgraceful policy, while good for asset-rich Western elites, not least politically-connected bankers, is a disaster for middle-income savers, not least pensioners, as the value of their home currency is destroyed. Oh, and now, as some of us have long predicted, QE is in danger of causing currency conflicts that could ultimately spark protectionism and all the economic damage that entails.

To understand what’s really going on here, headline nominal exchange rates should be ignored in favour of real effective exchange rates – which give a weighted measure of each countries’ currency against their actual trading partners.

Since September 2007, as a direct result of unprecedented Western money-printing and Tokyo’s refusal to do the same, the yen has appreciated no less than 22pc in real effective terms – a body-blow to Japan’s export sector. While eurozone politicians have lately been bleating about the yen, the single currency is currently down 5pc in real effective terms over the same period – something that’s disproportionately helped Germany, of course.

The dollar’s real effective exchange rate has also fallen, by over 6pc, since September 2007 – and there’s likely much more to come. In late January, the Fed’s balance sheet topped $3,000bn for the first time. If the US central bank keeps virtually printing at the current pace of $85bn a month for the rest of the year, as recently indicated, we’ll see another 30pc expansion by 2014.

When it comes to currency debasement, though, the UK is in a class of its own. Our jaw-dropping 350pc central bank balance sheet expansion has engineered a 15pc drop in the real effective sterling exchange rate since the start of 2008. For now, a lot of the UK’s QE money remains “inert”, and therefore not yet inflationary, the banking sector so far refusing to lend it on to firms and households – which is one reason the UK economy remains so weak. This stand-off will continue, in my view, until the banks have blackmailed the British government into following the Fed by sucking-up toxic corporate “assets” as well as government bonds, shoving yet more losses onto taxpayers.

Such kleptocratic nonsense must stop. Not least because, as Prudential CEO Tidjane Thiam has told my colleague Helia Ebrahimi, by extending QE further the UK would simply be “storing long-term trouble by minimizing short-term pain.” That trouble will come in the form of runaway inflation, another financial collapse and even more deeply entrenched moral hazard. It will also manifest itself, unless wise heads soon prevail, in the form of an all-out trade war.